Energy Income For A Peak 'Energy Return On Energy Invested' World

by: Plan B Economics

Many large cap integrated oil and gas companies have been hammered because of rising concerns over a Greek default and a China slowdown. The worry is that if Europe and China implode, oil demand will shrink causing oil prices to decline.

While the short-term case for avoiding oil might be compelling, perhaps the global economic turmoil is already baked into the cake. Frankly, if there's anything the past couple years has confirmed for me it's this: I don't know and neither does anyone else.

Tactical asset allocation is an extremely difficult and often destructive task. Instead, dollar-cost-averaging into a sound long-term investment thesis may be the best and most straight-forward way to accumulate assets.

Looking past the short-term fluctuations, over the long run I still believe that the global middle class will continue to grow and absolute oil production will approach physical capacity. More specifically, energy return on energy invested (EROEI), which likely peaked around 2005, will continue to shrink.

EROEI is the energy one must expend in order to obtain more energy. This ratio represents the physical constraint on global energy production capacity. Even if oil is discovered, if the EROEI to obtain that oil is less than 1 it will not be added to production. Essentially, the more EROEI falls the less production is added, and with new discoveries dependent on deep water drilling or arctic exploration this ratio is falling fast for new sources. This does not bode well for replacing and expanding oil production.

With growing middle class energy consumption and shrinking production capacity and EROEI, I believe the long-term fundamentals for energy are intact. With that said, I don't necessarily think oil prices will rise to infinity or in a straight line. The global economy has its limits (although limits can change with various economic conditions) and oil prices beyond those limits will crash the system. Do you think it's a coincidence that the peak oil price occurred a mere 2-3 months before the biggest financial crash and recession since the Great Depression? While leverage may have been the conduit that sent asset prices spiraling downward, the tipping point was when the greater fool had to choose between driving to work and paying the Liar Loan on his McMansion.

Of course - as we saw in 2008/2009 - when oil prices grind the system to a halt oil prices subsequently plummet. So to invest in a peak EROEI world is not to buy energy assets at any cost. In my opinion, it is to dollar-cost-average into volatile energy assets when they are trading at good valuations.

In my opinion, there are two basic ways to invest in energy companies in a peak EROEI world: 1) Speculate on the next big, high EROEI discovery, or 2) Buy the cash flow and distributions of existing company assets with more predictable EROEI.

For those looking to construct an 'energy income' sleeve within an overall portfolio, option two is probably the way to go. I view the energy income portfolio sleeve as the more conservative way to invest in energy since investors become an immediate beneficiary (through dividends) of producing assets of a group of major integrated oil and gas companies. (Although dividend-paying, major integrated oil and gas firms are relatively conservative compared to smaller exploration companies they are still risky investments.) Even if the major integrated oil and gas producers can't replace reserves (thus setting a finite lifespan on the company), at the right price an investor could view the stocks of these companies as amortized bonds or MLPs.

Below, I have outlined 10 large cap, integrated oil and gas companies trading with a single-digit P/E ratio. If you're smarter than me (and many people are) you might be able to research these companies to distinguish the dogs from the stars. Since I don't have the time or skill to predict the next oil spill, my preference is to build an energy income portfolio sleeve using a little of each. To assist, I have also provided averages for each metric.

Ticker Company P/E Forward P/E
(NYSE:CVX) Chevron Corporation 7.30 7.36
(NYSE:XOM) Exxon Mobil Corporation 9.90 9.28
(NYSE:OXY) Occidental Petroleum Corporation 9.68 8.83
(NYSE:COP) ConocoPhillips 5.65 7.72
(NYSE:STO) Statoil ASA 5.68 7.61
(NYSE:SNP) China Petroleum & Chemical Corp. 7.10 5.38
(NYSE:E) Eni SpA 7.17 6.31
(NYSE:TOT) Total SA 6.39 5.78
(NYSE:BP) BP plc 4.96 5.86
(NYSE:SSL) Sasol Ltd. 8.29 7.34
Average P/E 7.21 7.15
Click to enlarge

Each of these 10 companies provides a decent yield with a respectable payout ratio:

Ticker Dividend Yield Payout Ratio
CVX 3.62% 23.27%
XOM 2.78% 22.71%
OXY 2.67% 23.48%
COP 5.11% 28.27%
STO 4.82% 25.53%
SNP 5.19% 35.52%
E 6.90% 46.60%
TOT 6.81% 41.77%
BP 5.07% 18.37%
SSL 4.56% 39.63%
Ave. 4.75% 30.52%
Click to enlarge

Don't let the behemoth market cap, maturity or dividend payouts deceive you...these are profitable companies, as indicated below:

Ticker ROA ROE Operating Margin
CVX 13.31% 23.05% 19.12%
XOM 12.36% 25.84% 14.47%
OXY 11.08% 18.74% 43.43%
COP 7.70% 18.09% 9.02%
STO 10.77% 30.20% 30.68%
SNP 7.33% 16.42% 4.21%
E 6.35% 14.41% 16.12%
TOT 8.18% 19.11% 15.00%
BP 8.39% 22.11% 9.46%
SSL 15.07% 24.11% 24.23%
Ave. 10.05% 21.21% 18.57%
Click to enlarge

Also, despite their size and maturity their debt ratios appear fairly manageable:

Ticker LT Debt/Equity Total Debt/Equity
CVX 0.07 0.07
XOM 0.06 0.1
OXY 0.15 0.15
COP 0.32 0.43
STO 0.37 0.43
SNP 0.33 0.5
E 0.40 0.51
TOT 0.33 0.47
BP 0.33 0.39
SSL 0.12 0.15
Ave. 0.25 0.32
Click to enlarge

And the kicker is that many of these companies have been beaten down lately (after all, oil has corrected about $20/bbl):

Ticker YTD Price Change
CVX -5.09%
XOM -2.11%
OXY -13.26%
COP -4.95%
STO -4.82%
SNP -10.24%
E 0.70%
TOT -13.15%
BP -9.45%
SSL -8.39%
Ave. -7.08%
Click to enlarge

I'm still watching the tape, but these names are becoming more attractive with every down-tick. Of course, these stocks could go even lower, which is why I'm not committing massive chunks of money. I've only just started to chip away, but my plan is to dollar-cost-average into a range of these names over the next few months. If I can average into a group of major integrated oil and gas companies at reasonable prices and yields I plan to hold them for life.

Disclosure: I am long TOT, COP.

Disclaimer: Data source: This is not advice. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.